David Youngberg

Econ 310

Lecture 06: Exchange Rates and the Law of One Price

  1. Exchange rates
  2. As we discussed before, each country’s currency can be expressed in the form of any other country’s currency.
  3. Think of a currency as the right to participate in a country’s economy.
  4. A strong currency is high relative to others. Thus its exports are relatively more expensive. At the same time, the strong currency tends to attract foreign investment.
  5. A weak currency is low relative to others. Thus it tends to be less attractive to foreign investors. At the same time, its exports are relatively less expensive.
  6. When a currency becomes stronger, it appreciates. When it becomes weaker, it depreciates.
  7. Purchasing Power Parity
  8. Simply knowing how much of one currency you can get for another doesn’t tell you the full story. Just like money illusion, you must ask what you can buy.
  9. For example, until recently[1] 60 US cents would get you 1,000,000 Turkish lira. Sounds like a lot until you realize that much lira would buy you one ferry ride across the Bosporus.
  10. The purchasing power parity (PPP) is one reason why exchange rates are as they are. Becauseit took a million lira to cross the Bosporus, the lira was cheap on the international market.
  11. Another way to judge how much a currency can buy is the Big Mac Index, a form of the PPP.
  12. The PPP is calculated using the price of a common basket of goods in each country. However, quality of goods changes from country to country, biasing the index.
  13. The Big Mac, on the other hand, is completely consistent no matter where you go and so the Economist routinely (and half jokingly) publishes the “Big Mac Index.” However, cultural differences, trade laws, taxes, and other notions distort this version of the more generally used PPP.
  14. Law of One Price
  15. The PPP and exchanges rates naturally lead to the law of one price—prices between identical products in different countries will converge, assuming transportation costs are low.
  16. The intuition works much like basic economics. If two firms produce the same good, but one’s twice as expensive, market forces will pull the two prices together.
  17. The only difference here is that since we are looking at both different prices and different currencies, we must consult two different sources (the PPP and the exchange rate, respectively).
  18. The law of one price is not an instantaneous notion. Prices converge over time, but not all at once. Transportation costs are also often high, though for some goods it has become virtually nothing thanks to information technology.

[1] In 2005, Turkey revalued their currency, effectively slicing off many zeros. So far the new lira looks pretty stable and has not yet fallen victim the same hyperinflation its namesake experienced.